Capital Returns: Investing Through the Capital Cycle: A Money Manager’s Reports 2002-15 [Edward Chancellor, Editor]

A collection of essays, culled from Marathon Asset Management's letters to clients, unified into what turns out to be an uneven book: useful in places, nearly useless in others. However, it offers readers good insights on how to think long term about investing in stocks, and the "capital cycle" (which I'll explain in the next paragraph) is an extraordinarily useful paradigm for investors.

So what is the "capital cycle," and how do you invest "through" it? Essentially, all companies have capacity decisions to make, all the time. They have to expand capacity to meet market demand (or contract if there's a decline in demand), and they also have to game theory out what their competitors are thinking about their capacity. Every industry has its own dynamics, of course, but when an industry is in oversupply (in other words it has too much capacity), business quickly becomes terrible, earnings drop, and stock prices go down. And when the reverse is true and an industry faces shortages (because there's too little capacity), business is great. Companies can raise prices, they all earn peak profits, and everybody's stocks go up. 

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The problem is that companies--due to greed, hubris, delusional optimism or whatever--inevitably overestimate how long the good times are going to last, and they always, always overexpand into that delusional optimism. The upcycle then necessarily brings about the downcycle: all that excess industry capacity wrecks pricing, wrecks profits and often drives the weakest companies out of the industry entirely. And then, as the downcycle forces a reduction in excess capacity, a new upcycle begins.

To really think about their stocks this way, you must think in investment time horizons of years or sometimes decades, rather than holding periods of days or weeks (or these days, hours and minutes). But this framework, once you internalize it, helps keep you from getting sucked into the euphoria of an upcycle, and it helps you invest aggressively when everybody hates an industry. Thus you always want to ask the metaquestion "where are we in the cycle?" with any investment you make. Always ask this.

There's an interesting discussion early on in Capital Returns about why most investors, even at the institutional level, either get the cycle wrong or fail to think about it at all. There are lots of reasons, but mainly, it has to do with lack of experience. There's an eternal September phenomenon in Wall Street, where there's always new, young and inexperienced people coming into the industry who have never seen a true market cycle. I'll confess: this happened to me too! I started my career during the last few years of the 1990s tech boom, a time when it was universally believed that tech would grow forever, the internet would grow forever, and ... well, you know the rest. Even in that unusually long-term secular growth era, there was still a massive cycle into overcapacity, which led to a terrible downturn, lots of bankrupcies--and then, finally, a glorious time to put money to work.

What's even more sad: I didn't really fully grasp these cyclical dynamics even after living through that incredible cycle. It wasn't until I started covering materials, metals, mining, and industrial stocks--all violently cyclical industries--that I finally started to get through my thick head what kinds of (often catastrophic) things happen across periods of excess capacity followed by capacity reduction. I simply couldn't see it... until I could.

And so what I recommend to all investors--especially beginner- to intermediate-level investors--is to make a few small industrial stock investments; a chemical company, a mining company, etc., and hold them for years. Live through an entire capital cycle, or better, a few capital cycles. Watch how it plays out; see how it feels. Experience the temptations you have across the upcycle to give in to the euphoria, and experience the temptations during the downcycle to give in to despair. You'll learn a tremendous amount about investing, and yourself. I'm serious.

Thanks for listening! Now a few more comments about the book, some cautionary. I'll start with a refrain I often write about here: that you should never read investing books during the period they were written, ever. Here, our authors are way too "early" in many of their calls: they "saw" the real estate crisis coming so many years ahead of time as to be useless; they were years early in citing problems at various banks; and their prediction that the private equity bubble would burst still hasn't happened, even decades later. Thus readers should be warned that these guys are congenitally early.

Note also that Part II, basically the entire second half of the book, is the weaker part of the book. It can be skimmed by a time-constrained reader, and the final chapter, Chapter 7: Inside the Mind of Wall Street should be skipped by all readers, time-constrained or not. The key insights of Capital Returns come from explaining how to think about the capital cycle: this is the meat of Part I. Part II unfortunately contains far too many examples of the authors going against their own advice and "predicting the top" in various stocks and stock market sectors. And, once again, most of their predictions were so early as to be useless to a contemporaneous reader.

A final comment about writing. Investors invest and writers write. It's not impossible to find an investor who can articulate his thoughts clearly in writing, but truly great writers are almost always terrible investors. I don't know why this is, but yet it is. What this means is most investment literature suffers from a structural flaw: if it is written very well you should judge it suspiciously. Note that the various investors who authored the essays in Capital Returns are competent writers, not great writers, and so they pass the test.

[Readers, first let me apologize for a much longer than normal essay! Unless you are interested in investing and really want to learn more about capital cycle investing, feel free to stop reading right here. As usual, what follows are just my notes and quotes from the text.]

Notes: 

Foreword

x "...high returns tend to attract capital just as low returns repel it. The resulting ebb and flow of capital affects the competitive environment of industries in often predictable ways--what we like to call the capital cycle. Our job has been to analyze the dynamics of the cycle: to see when it is working and when it is broken, and how we can profit from it on behalf of our clients... The best managers understand the capital cycle as it operates in their industries and don't lose their heads in the good times."

Preface

xiiff Edward Chancellor explains the book here: it is a collection of edited and tightened up essays from the Marathon investment team, a group of some thirteen authors. [Note that Chancellor is the author of (the somewhat disappointing) The Price of Time, a book about the history of interest rates, as well as Devil Take the Hindmost, a readable history of market bubbles and crashes.]

Introduction

1 On the capital cycle, excess returns attracts capital, and capital leaves a sector when returns fall below the cost of capital; this process is cyclical and in constant flux. The inflow of capital leads to new investment which increases capacity, which then eventually pushes down returns; and then when returns are low capital leaves the sector, capacity is reduced and then over time profitability recovers... and then you repeat the cycle. The idea of capital cycle analysis is to see how the competitive position of a company is affected by changes in industry capacity, thus they focus on an industry's supply side. "Capital cycle analysis is really about how competitive advantage changes over time, viewed from an investor's perspective."

3 "High current profitability often leads to overconfidence among managers, who confuse benign industry conditions with their own skill--a mistake encouraged by the media, which is constantly looking for corporate heroes and villains." Also everyone is skewed to short-term payoffs: management as well as the investment community. They're all given to extrapolating current trends, "In a cyclical world, they think linearly." Also on supply chains being lumpy and prone to overshooting: see the "cobweb effect" in the photo below which illustrates the market instability created by lags between changes in supply and production:

4  On the idea when a beaten down stock sometimes can be very interesting if you have a longer time horizon than the investors alongside you (as well as the street, which is overfocused on all the near-term uncertainty). On certain industries with violent capital cycles, like semiconductors, airlines; see also the fiber optic boom; the shipping/tanker industry which massive increased capacity from 2004 to 2009. [A couple of thoughts here: 1) note that during this awful downturn ships continued to be delivered (thus already excess capacity continued to increase) because they had three-year order lead times! 2) Note the other side of this irony today: these ships are being decommissioned right now as they age out of service and the industry is likely in structural undercapacity] 

4 See photo for the capital cycle process:

11ff Attempts to explain the market inefficiencies observed by capital cycle analysis. The authors blame it on corporate manager overconfidence and their infatuation with asset growth and expansion; also on "competition neglect" where multiple competitors in an industry expand capacity, but don't pay attention to each other's similar actions; also "base rate neglect" where investors ignore changes in the industry's asset base from which returns are generated; also the so-called "inside view" which is a sort of an error of framing: you think that your situation is unique and you don't see analogies elsewhere that will help you calibrate your forecasts better; you might think your industry is special or your knowledge of the industry is special. Also on other behavioral finance explanations like extrapolation.

13ff Still more reasons for the capital cycle anomaly: skewed incentives, CEOs get paid on short-term performance or expansion due to major capital projects; pay is often based on company size; also the investment banking sector (which capitalizes industries) gets paid on deal flow not outcome. [As Buffett famously said about investment bankers: "Never ask the barber if you need a haircut."]

16 Also on the prisoner's dilemma/game theory that happens within an industry: if everyone expands capacity everyone's profits go down, but if only one company expands then they get all the upside from that expansion.

16-17 Notable point here on how it's difficult to arbitrage or short away the capital cycle anomaly (mainly because of the career risk, they argue, as investors who take risks outside of the herd typically get fired if they end up being wrong); but here the notable point is how Marathon, because of its private ownership and long client relationships, can use a longer-term approach than most other investment firms, thus it can be "more tolerant of benchmark deviation." This is possibly the most important thing any investor can have! You're not fragile to your clients taking the money away.

17ff Good tight statement of Marathon's investment philosophy here: "Marathon's approach is to look for investment opportunities among both value and growth stocks, as conventionally defined. They come about because the market frequently mistakes the pace at which profitability reverts to the mean. For a 'value' stock, the bet is that profits will rebound more quickly than is expected and for a 'growth stock,' that profits will remain elevated for longer than market expectations." Next is a discussion on why to focus on supply rather than demand: demand is too difficult to estimate/forecast whereas supply is far easier to forecast. "In fact, increases in an industry's aggregate supply are often well flagged." "...stock prices often fail to anticipate negative supply shocks."

18-19 "The capital cycle analyst is particularly wary of the actions of investment banks, and the work of their in-house propagandists, the brokerage analyst... The good capital cycle analyst is a contrarian by nature and always sceptical of the siren call of Wall Street." Also on how CEOs tend to not be good capital allocators; also industry specialists tend to have "narrow framing" and an "inside view" whereas generalist analysts tend to make better capital cycle analysts. Comments here also on how capital cycle analysis requires patience, and then examples of how Marathon firm was very early warning of mining capacity expansion some five years early. [Note that there are worse examples, as we'll see later in the book, when Marathon was waaaay too "early" in warning about overexpansions.]

20 Comments here where capital cycles can break down under technology substitution; see how the internet replaced many industries; see also where policymakers will sometimes protect entire industries like the banking industry or auto industry, see also outright state sponsorship (like in China) can disrupt what "should" happened in a normal cycle. 

20-1 8 Good set of bullet points articulating the essence of capital cycle analysis:

* Most investors devote more time to thinking about demand than supply. Yet demand is more difficult to forecast than supply.

* Changes in supply drive industry profitability. Stock prices often fail to anticipate shifts in the supply side.

* The value/growth dichotomy is false. Companies and industries with a supportive supply side can justify high valuations.

* Management's capital allocation skills are paramount, and meetings with management often provide valuable insights.

* Investment bankers drive the capital cycle, largely to the detriment of investors.

* When policymakers interfere with a capital cycle, the market-clearing process may be arrested. New technologies can also disrupt the normal operation of the capital cycle.

* Generalists are better able to adopt the 'outside view' necessary for capital cycle analysis.

* Long-term investors are better suited to applying the capital cycle approach.

Part I: Investment Philosophy

Chapter 1: Capital Cycle Revolution

25ff On the prisoner's dilemma game and the tit-for-tat strategy that emerges. "The trick is to identify conditions where cooperative behaviour can exist or may evolve, while avoiding those industries where this is unlikely to happen." The author cites an industry with a history of poor returns as a possible example, where a small number of players emerge from a situation of excess competition and then exert pricing discipline. See as a contra-example the auto industry, with examples like Volkswagen, which more interested in market share, and where its largest shareholder (the state of Lower Saxony) cares more about local employment conditions in its region.

27 On the tit for tat strategy revealing the shadow of the future because it "has a bearing on decision making in the current game." Participants are less likely to defect if they know a retaliation will result. [See related discussions in the book Algorithms to Live By, in particular Chapter 11 on game theory]. Also on other factors like barriers to exit that keeps an industry in crappy conditions permanently; see also lower than appropriate interest rate policy. "A basic industry with few players, rational management, barriers to entry, a lack of exit barriers and non-complex rules of engagement is the perfect setting for companies to engage in cooperative behaviour. ...the really juicy investment returns are to be found in industries which are evolving to this state."

28ff On the cod fishing industry [see Mark Kurlansky's book Cod]; the authors give a great example here of reading a book that has nothing to do with investing but yet can help an investor if you read looking at it through an investing and competition lens. [You can make a similar case for Dan Norman's book Merchants of Grain as well as Matthew McCleery's The Shipping Man, both of which are extremely useful: you really get to see, over the history of these industries, the up- and downcycles that happen, how they play out, the second-order reactions, etc.] Discussion of what the authors call a pinch-point in the industry: see for example harbor space where the cod was processed; then example of technological advancement like food freezing in the 1920s, sonar in the 1930s, and steam-powered trawlers which combined to squeeze out the old harbors where fish used to be cured, dried and salted prepared etc. Also on the major capital investment required to participate in large-scale cod fishing, bringing about overfishing, price wars and a global tragedy of the commons-type problem.

30 On finding companies that control their own pinch-point; also on capital cycles that destroy profits in an industry, like the Bessemer process which commoditized steel; big box department store retailing; and then thinking about how long this process takes: Note with semiconductors aspects of this process happen in just a few years, whereas with the Bessemer process it took the steel industry 70 years to reach commoditization. The big box phenomenon in department stores occurred over 30 years.

31ff A 2006 note discussing rising commodity prices in the early 2000s based on underinvestment in the mid- to late 1990s, and also due to demand from China and India and other emerging economies. "Indeed, mining companies have certainly responded to the pricing situation in the way one would expect: initially they were sceptical of the price rises, but later they started investing heavily to bring on new supply." [This is the same rhythm you'll see every single time. Note however these guys were ridiculously early with this call, so early as to be money-destroying, see below, p33.]

33 Also mention of the bubble in the container shipping industry in the 2000s, another instance where we were promised a supercycle due to previous underinvestment; also Note that an M&A frenzy in 2005 "marked the peak of the cycle." The authors also cite the 94% drop in the Baltic Dry Index, this could be a line take right out of The Shipping Man! 

33ff Now a note from 2011 arguing "the commodity industry is showing the classic signs of a capital cycle peak." But wait, this is FIVE YEARS LATER than when they warned of the same problem back in 2006, the note that was featured just a few pages ago! Note that even this 2011 note was still a bit early, as the real underperformance didn't start until January 2012. [A couple of takeaways here: all investors and investment firms make embarrassing calls like this one, but the important thing to note here is that despite having beaten a drum for beginning six years before the cycle turn actually happened, they still claim they were "right" when obviously they were so early as to be clearly useless. A second takeaway: even if you try to control for being early, you're still going to be early. Upcycles take longer to end, and downcycles take longer to clear. You're always gonna be early.] Finally, the authors cite global mining capex up a staggering 6x over a 10 year period, from $30b to $180b.

37ff On beer industry consolidation from 2002-2010, to the point where two players held 80% of the US market, and four players held half of global supply (compared to 13% in 1998). (!) [What a beautiful oligopoly. Beer drinkers hardest hit.] On beer demand being flat in developed markets but growing in emerging markets; on pricing increases; and then a reduction in global brewing capacity.

40ff Comments on the oil sector and a capex boom; comments on Total, Petrobras; on various risks that can happen to oilfields: they can be captive assets to nation states; more capex is always needed as the field "ages"; also on how major oil companies tend to anchor to higher oil prices when they map out their capex plans, etc.

45ff  Good chart here on page 46 illustrating the "fade rate" concept: where investors typically misforecast mean reversion from good to mediocre or terrible to mediocre:

47ff On Vestas, a wind turbine company that Marathon held too long: the stock went up 40x and then went down 96% (an ignominious "Return to Go" as they phrased it); the company was victim of an alternative energy capital cycle. Note also after this downcycle Marathon bought much more stock as a new chairman came in during a capacity rationalization period.

48ff On the "growth paradox": the fact that corporate earnings lag GDP [when you'd think they would at least equal GDP or perhaps even exceed it]; drivers of this phenomenon are share issuance, usually from procyclical buybacks and sales [meaning companies doof out and buy their stock back at high prices only to need to sell shares and raise equity capital during the next downturn], also procyclical M&A [ambitious acquisitions at the cycle top]; also dilution due to shares/options given to employees. 

Chapter 2: Value in Growth

52ff On stocks that defy mean reversion; on moats around a business; on how the value/growth dichotomy is false, in fact it grossly distorts the investment process. Also on instances where one person's growth stock is another person's value stock. Also post the tech bubble, many growth stocks quickly became value stocks.

 

55 "Investment style labeling is another convenient box-ticking, quantitative oriented procedure beloved of consultants."

55ff On the merits of having low turnover, long term holding periods, lower frictional costs, fewer decisions, fewer mistakes; on the idea of asking more valuable questions about an investment, rather than trying to guess short term outcomes (where competition for that information is ferocious, and only has temporary value anyway). Also useful thoughts here on Colgate-Palmolive and its marketing spend and line extensions; the stock is up 25x since its first line extension in the early 1980s (to 2003), although since the share turnover in the company is 100% annually, very few investors captured that gain.

57ff On "psychological forces stacked up against the long-term investor." On different types of agency problems that create opportunities: see for example on plumbing products where the plumber (the agent) gets a percent of the job, thus he has a direct interest in price hikes from the equipment suppliers, even though this is contrary to the end customers' interests. See also in the healthcare sector, where there's another unholy alliance between producers and distributors in dental implants and hearing aids; see also Labtest/Intertek, a gatekeeper between Chinese manufacturers and American retailers to test prototypes. "Customers will often pay more when agents are involved."

60ff On digital moats: see Amazon building a long-term competitive advantage using low margins in the short term; basically the online application of Wal-Mart's strategy.

65ff On the semiconductor industry, these guys cite ADI and Linear Technology here; on barriers to entry in the analog semiconductor market; note also the products are important but yet they represent a tiny percent of the full product costs (like a $2 crash sensor in a $35,000 car) with "sticky" design slots.

70ff On pricing power derived from intangible assets: examples here would be oligopoly industries or situations where a company has intrinsic pricing power (like when the customer simply doesn't sweat the price at all); on branding; on "stickiness" (high switching costs) in companies like ADP or ORCL that are deeply integrated into a firm's workflow; instances where scale or increasing returns repels new competition (P&G); on short-termism in investors; also on investors overfocusing on the income statement instead of the cash flow statement.

73ff On unglamorous but essential (and often invisible/under-the-radar) companies; again mentioning analog semis and payroll processing companies; flavor and fragrance companies; enzyme makers; lab equipment and supplies; a good anecdote here about Waters Corp [ticker: WAT] not even able to replace or displace their own old technologies! These are all "invisible" companies in a lot of ways, both to their own end customers and to investors.

Chapter 3: Management Matters

76ff On paying attention to management's capital allocation skills, which is "decisive" to investment outcomes. "The case of Bjorn Wahlroos of Finland's Sampo, outlined in this chapter, shows how the ideal corporate manager is one who understands his industry's capital cycle and whose interests are aligned with those of outside investors."

77ff First there's a (useful) side discussion of systematic flaws in the specialist analyst model, using the company Ahold as an example. Analysts are too close to management, which is a form of capture [Jack Grubman here would be a textbook example of analyst capture, dating back to the late 1990s telecom boom and bust]; there's too much information: "Having more information doesn't necessarily improve decision-making" [but it does make you that much more epistemically overconfident about your decision-making!] Also re Ahold, note that cash flow statement showed that the company wasn't generating any cash from its core business; specialist analysts covering just one sector or industry tend to live in a cocoon, thus they'll be burdened with an "inside view"; also there's a herding instinct among the analyst community; one-industry specialists are less able to compare a company or industry to other industries (say for example to consider cash flow metrics from a totally different company for comparison); analysts tend to overfocus on earnings per share, which is a metric subject to Goodhart's Law ["the measure becomes a target" thus companies massage or manipulate earnings]. Note that Marathon actually invested in Ahold after its accounting scandal was exposed and after they switched their executive bonus schedule from targeting EPS to targeting return on capital employed instead.

80ff On why managements usually buy stock high and sell low; why they engage in procyclical behavior, buying back their shares at cycle peaks only to raise capital and dilute shareholders at cycle troughs. Examples given here of several European building materials companies who bought back shares in 2008 but then issued new shares at market lows in 2009; likewise European homebuilders, the European auto sector, etc.

82ff Now [finally] onto Sampo and shareowner/CEO Wahlroos: discussion of how many company CEOs and managements are not skilled in capital allocation because they rise to the top of the company due to skills in marketing, production, engineering or [worst of all] institutional politics. On Wahlroos as the exception; he became CEO as his boutique investment bank was acquired by Sampo for shares. Comment here on the insurance industry "combined ratio" which is the sum of incurred losses and expenses divided by earned premium. Above 100% equals an underwriting loss; below 100% equals an underwriting profit; Wahlroos presided over a period of consolidation and oligopolization of the Scandinavian property and casualty insurance industry; sold off a huge stake of Nokia stock; then did a sort of arbitrage by selling Sampo's retail banking business at 3.6x book value and then buying a stake in a separate banking group at 0.6x book. "The Sampo case study combines many of the key elements that we look for in management; namely, it has a chief executive who both understands and is able to drive the industry's capital cycle (the Nordic P&C consolidation story), allocates capital in a counter cyclical manner (selling equities prior to the GFC), is incentivized properly (large equity stake) and takes a dispassionate approach to selling assets when someone is prepared to overpay (Finnish bank divestment)."

85 Discussion of the Scandinavian success story in equity markets; on high quality Nordic management teams; on the fact that small Scandinavian countries with small populations naturally produced companies good at trade, with an outward, global orientation, etc.

88ff Amusing comment here on executive pay. "We cannot recall a situation where a company proposed to reduce remuneration of top executives in the basis that it was above the peer group median." On metrics for management bonuses; EPS is too easily gamed; better to look at total shareholder returns, returns compared to industry or industry benchmark or stock market benchmark.

90 "Since the average holding period for European shares is down to 12 months, the average investor has little interest in the performance of a company over a five-year period."

Good lord Anon, how can you NOT make money when the average shareholder holds a stock for barely eight months?

91 On insider ownership as the most direct way to deal with the principal/agent problem; on looking either for companies where successful entrepreneurs retain large shareholdings or where companies require executives to build up large shareholdings; see also HSBC which revamped incentives such that deferred share awards vest after five years but must be held until retirement.

91ff on solving the principal/agent problem through family control of companies and investing alongside an aligned family; note the countervailing risk here of nepotism and possible paralyzing family disputes; also note that a third of the companies in the S&P 500 are under family control [can this possibly be true?]. On evidence that companies with large family stakes outperform; and families are better able to withstand short-term profit fluctuations and think more long-term. [See Dan Norman's book Merchants of Grain to see this family dynamic very clearly laid out across the history of some of the world's dominant grain firms.]

93 Comment here on the Anna Karenina principle, which shows up in statistics, ecology and other domains: for a marriage to be happy it must succeed in several key aspects, while failure on even one such aspect produces an unhappy marriage. [You need a lot of things to go right, but you only need one thing to go wrong.]

93ff Marathon gives readers a list of common family deficiencies in corporate ownership, including 

1) lack of family unity: see for example the Gucci family and also the Mondavi family in California which suffered two generations of family sibling rivalry; see also the dispute of the brothers who owned Reliance group in India, leading to the company's breakup.

2) loss of business acumen: see the Buddenbrooks Effect, named after Thomas Mann's novel, where after a few generations the family becomes more interested in the trappings of wealth rather than its generation. See Estee Lauder in the US for example.

3) self-dealing.

4) poor succession planning: see certain Asian family-owned companies that failed to replace their octogenarian founders.

5) politics of rent seeking: see what happened to Egyptian companies close to the Mubarak regime as the tables turned in that country's political environment; see also Carlos Slim who managed to keep a near monopoly with Telmex but then later got in trouble for monopolistic practices with his cellphone company America Movil; better to find companies that are actually competitive rather than flagrantly rent seeking.

95ff Discussion here of Johann Rupert, the CEO of Richemont, a Swiss luxury goods company in which his family owns a controlling interest; Marathon looks over this guy's performance as he prepares to retire in 2013. "We have collected the lower number of throwaway comments from Mr Rupert...which illustrate to our mind why he has been such a successful Steward of other people's money."

* Don't play cat and mouse games if you're the mouse (speaking about relations with a dominant supplier).

* I raised a glass of champagne when Al Dunlap fell on his chainsaw.

* Ultimately, if any asset is wrongly priced, it is abused. [Holy cow is that ever a good one!]

* If you look at share buybacks, and at the prices at which companies bought their shares back, they inevitably bought the shares back a very close to the top of the market because that's when they had a lot of cash. And boy, do they regret it when two years later all hell breaks loose.

* When the Chinese nouveau riche want to spend, they do not want to buy Chinese.

99ff Interesting discussion here about how it is pointless to meet with CEOs to try to turn up short-term information when managers are now so well prepared by PR advisors; better instead to use a CEO interview to judge the individual, to find out for example if the CEO thinks in a long-term strategic way, if he understands how capital cycles operate in their industry, does the CEO appear trustworthy and honest and likely to act in a shareholder-friendly way? Also on interview formats to avoid, like the large fireside chat format; better to have a small dialogue directly with management without hangers-on, analysts and attendants. The authors also write interestingly here about looking for signs of humility, like recognition of past mistakes, or asking a promotional CEO what's not working with the company, or watching how they interact with their other lieutenants, or looking for signs of individual curiosity like the CEO taking interest in our [Marathon's] own business. Other cues: "Signs of vanity are generally off-putting." Also a story about a CEO seen carefully adjusting his bouffant hairstyle in Marathon's bathroom. [You can put this alongside Marc Cohodes' 100% reliable "wig indicator": any CEO with a hairpiece is a great short.]

102ff On corporate culture: citing Kotter and Heskett's book Corporate Culture and Performance; that strong cultures produce extreme outcomes, "both exceptionally good and dreadfully bad." On a cultural emphasis on cost cutting; or the contrary example of an emphasis on spending more: see Costco the retailer which pays its staff more than the minimum wage and far more than rivals. Also citing a counterexample of AIG, dominated by Hank Greenberg, creating "a culture of complicity." [This is likewise extremely perceptive and very true]; likewise and unhealthy culture obsessed with growing earnings can lead to outright fraud, see "Chainsaw Al" Dunlap at Sunbeam.

104 "We are constantly looking out for signs of management extravagance and vanity. Danger signs include expensive executive travel (a corporate jet is liable to elicit groans), too numerous pictures of the CEO in the annual report, and dandyish attire." [Hot!]

Part II: Boom, Bust, Boom

Chapter 4: Accidents in Waiting

107ff On using capital cycle analysis in both the banking sector and the housing sector in the years leading up to the great financial crisis.

109ff Discussion here of Anglo-Irish Bank after Marathon met with the company multiple times; the company shares its notes from meetings with management over time, dating back to May 2002: one note saying "This will one day be a super short"; note the stock had doubled since September 2001, and was up 7x since 1997; comments on the promotional nature of management; comments on the bank's business model of "speed" and being able to say yes to a lending decision quickly; [There's a lot a perceptive reader can say here: for one thing, from 2002 to 2007 Anglo-Irish went from EUR2.5 to EUR17. The management team met with the company multiple times just in 2004 alone! So were these guys right to say this stock was "a super short" in 2002? Obviously not, the stock proceeded to go up nearly 7x. Further, should an investment firm miss an investment like on the way up? You don't have to catch every winner out there, but if a major company goes from 2 to 17 in a matter of a few years: you not only missed it all but you were bearish and wrong the whole way up--despite having multiple meetings each year with the company! A cynical reader here might ask, "if you're so smart about capital cycle analysis then why don't you guys recognize that there will be an upcycle before the downcycle?"]

115 It's interesting and a bit sobering to read their comments on Anglo-Irish here, such as "All of the managers have boozy faces..." These kinds of comments sound like the very narrative-fitting they criticize elsewhere in the book.]

119 On the Minsky idea of "speculative finance" applied to Anglo-Irish Bank, where borrowers covered their initial interest payments but not principal payments. This is the second stage of the Minsky scale, not yet the final stage of "Ponzi finance" where the borrower can't even make interest payments from current cash flow.

120ff On asset securitization and how it "supplies capital at an abnormally low cost to inherently risky activities, delaying the normalization of profits and storing up losses for the future. This has capital cycle implications." [Those implications appear to be that companies can get away with cheating the capital cycle more than these guys would like!] The authors give an example in the airline industry of a purchase order for an aircraft at a discount to list which is sold to an airline close to list, but then leased back to the manufacturer, which then issues tranches of securities based on those lease payments. Of course the junior tranches of these securities get bankrupted first. [Note that the authors really should have led here with a discussion of how a mortgage does this, not an airline; they give an example of a mortgage securitization very briefly right after.] The trade-off here is the packagers of the securitized mortgages don't care about the underlying economics of the mortgage [Sure they may not, but note that in this domain buyers as well as the sellers are fiduciaries, they are "consenting adults" who have to know what they're doing.] "Securitizations have been an effective way of obscuring the real economics of these activities, while facilitating the inflow of more and more capital." [Again a careful reader will notice, once again much like the Anglo-Irish note, that this was written in 2002, several years before it became a remotely profitable insight. It doesn't help to discover something so early that you get your face ripped off trying to play it.]

122ff On private equity, including a shocking statistic that in 2004 up to 1/5 of the UK private sector workforce was reportedly employed by private equity firms. [This can't possibly be right.] On private equity firms resembling the 1960s-era conglomerates, the authors wonder whether this means they'll suffer the same fate, or do they now play "an essential role that cannot be fulfilled by public capital markets?" They note that PE firms don't have the obsession with quarterly earnings; restructuring/cost cutting under private equity ownership can be easier to achieve; also management pay isn't scrutinized the same way it is it publicly traded companies; also it reduces the principal/agent problem because the owners, the private equity firms, have control of the business.

123ff After stating the positives of PE, they go through the long list of negatives of the private equity boom [note that some of these reasons are more rigorous than others]:

1) it depends on banks being willing to fund deals on lax terms; also the lending typically involves more leverage and non-recourse up to the private equity parent, thus the bank lender exposes itself to more risk

2) high debt levels are dangerous to highly cyclical businesses

3) private equity firms are awash with cash [presumably this means they overpay for assets? This isn't bad for sellers of those assets...]

4) the historical returns look really good but it is mostly due to leverage

5) private equity firms are outbidding trade buyers

6) there's a lack of transparency in the private equity world

7) anecdotal signs of a private equity bubble [this particular note is from 2004, yet again wayyyy early, actually you could argue a private equity bubble didn't really happen, ever, even now some 20 years later] "Private equity has become one of the most sought after career options for MBA graduates--reliable contrarian indicator."

8) incestuous exit routes where private equity firms sell a company to another private equity firm [if the authors thought about this bullet point a little more they probably would have and should have deleted it.]. 

9) private equity firms produce billions of dollars of fees for investment banks, lawyers, accountants, lenders etc. [This is no different from regular public equity markets.]

10) [another logically incontinent bullet point here] citing Allianz's foolishness about private equity when they themselves overpaid for Dresden Bank in 2001 and also sold equities in late 2002 at the bottom. "In short, there is a good chance that the capital cycle and private equity, as in hedge funds, is about to turn nasty." [This isn't even relevant, people are wrong all the time about the acquisitions they make; note that this note was written in 2004 and again, no real bubble burst in the private equity world ever since, thus pointing out that Allianz was wrong when Marathon actually turned out to be wrong is extra ironic. Finally, note the footnote at the end of this section saying how Marathon failed to anticipate the extent to which private equity firms would benefit from ultra low interest rates: this is an excuse of a reason. It's like claiming that "the central bank is to blame for why the crash I predicted would happen never happened." Either your crash prediction was right or it was wrong. You don't get an asterisk because you would have been right if something hadn't happened that made you wrong.]

126 Here's a [rare non-early] note to their clients from 2006 about how "several indicators of speculative activity suggest the market peak has been reached." They cite commodity bubbles, and in particular the gold price ("the gold price has recently touched a 25-year high") [Note that it's quite an interesting experience reading this in 2006 and thinking back to what commodity prices have done in the 19 years since...which is go up an absolute crapload after having gone down modestly during the GFC. If you look at gold particular you can't even see the blip of a decline during the GFC, it dropped maybe 10-15% during the crisis but has tripled since then! It sounds like these guys don't really fully grasp the dilution of the monetary base happening here]; citing private equity mania, the IPO "frenzy" [this is a perennial favorite "reason" permabears tend to cite that a crash is coming], the M&A mania, insider selling, and finally "the antics of the retail investor" [the things are describing here are far from antics, things like in flows into emerging markets, or the authors citing that "the retail crowd" is behind some 60 percent of options trades on the NYSE"--I have absolutely no idea how they can possibly know that]. [Another irony of investment writing is this is one the least logically rigorous of the notes in this entire book, and yet it turned out to be the most predictive! It was posted only a little over a year before the crisis. The market humbles us all and it traffics in cruel irony.]

130ff A brief section here on what the authors call "pass the parcel"; originating a loan and then passing it off or selling it to another holder; they are suggesting that this means lending standards drop in aggregate. [It's clear at this point that this section, Part II, is by far the weaker part of the book: it gets too involved in "predicting the top" predicting when a stock or a sector is overvalued, while oddly enough in the prior section the authors just got done saying that this is very difficult to do--and yet this is all that they're doing here. A further irony is their predictions are in general pretty far off the mark, generally they "predict" things so far before they happen as to be useless.]

132ff A 2007 note here on the building boom in Spain; on construction being 15-20% of Spain's economic output, compared to the European average of well below 10%; also on Spain accounting for half of Europe's cement consumption with less than 15% of the population; see also Astroc Mediterraneo, a Spanish real estate developer, which was a 10-bagger in two years, but then collapsed in 2008 (including declining 70% in one week) after an accounting scandal emerged.

135ff Another 2007 note here on the two German banks that collapsed because they held too many mortgage-backed securities from the United States. [I remember when this happened: it was absolutely weird to learn that some random regional German bank got itself stuffed full of subprime MBS paper!]

138ff On Northern Rock, a UK bank that failed in late 2007; the authors talk about Marathon's meetings with the company which "left us baffled" as the CEO was "a bit too clever by half" and the company had plans for a huge new headquarters.

141ff Discussion here of the Swedish Bank Svenska Handelsbanken, which sailed through the financial crisis [as well an early Swedish banking crisis in the early 1990s]: good insights here on how Marathon--by meeting frequently with this bank and having a long-term holding in it--got to know not just the bank itself but discovered insights about the industry and the actions of other banking firms as well.

141ff On the seven deadly sins of banking:

1) imprudent asset-liability mismatches on the balance sheet (like funding mortgage loans with short-term paper, and calling the interest rate delta between these two things "profit").

2) supporting asset-liability mismatches by clients. Examples here would be offering Swiss franc mortgages or Euro mortgages to Latvian or Hungarian customers who operate in their own currency. 

3) lending to "can't pay, won't pay" types of borrowers, rather than lending to people with money [lots of people struggle with this, but the best people to lend to are the people who never needed the money in the first place].

4) reaching for growth and unfamiliar areas, like investing in US subprime debt.

5) engaging in off-balance sheet lending like conduits and SIVs; likewise engaging in moneylending to those who are in the business of lending money as well. [Thus Svenska Handelsbanken stayed out of the "pass the parcel" securitization trend across Europe.]

6) getting sucked into virtuous/vicious cycle dynamics: here an example would be lending to the Baltic states because their GDP was growing rapidly when this was actually growth due to rapidly expanding credit supplied by the banks themselves. [!]

7) relying on the rearview mirror: like using VAR models to quantify risk. 

144 A discussion of Svenska Handelsbanken's foundation, which looks kind of like an employee stock ownership plan, but the criterion under which it pays into the plan is aligned with the dividend to shareholders. Interesting structure here.

Chapter 5: The Living Dead

145 On the decline in stock prices after the GFC, providing opportunities where capital was rapidly withdrawn from various sectors/industries [the GFC was really the mother of all capital cycles as it affected zillions of industries, not just banking/real estate]; on the capital cycle then moving into a "benign phase." "Capital cycle analysis is strongly influenced by J.A. Schumpeter's notion of creative destruction, namely that competition and innovation produce a constantly evolving economy and spur improvements in productivity." Comments here on how European policymakers prevented the benign phase of the cycle happening in industries that are employment-heavy, like the auto sector or the banking sector; excess capacity and weak profitability didn't go away, these policy decisions ended up producing corporate zombies, etc.

146ff A November 2008 note on the inversion of the earlier bubble signs, which included: 

* declines in commodity prices, commodity firms shelving plans to expand capacity; 

* a collapse in private equity valuations (see Blackstone shares down 81% since the firm's June 2007 IPO [note that if you punch up ticker BX you'll see it bottomed around $4-5 a share. It's now $170], the Apollo fund down 86%, other examples here

* no deal activity, low M&A activity

* insiders buying rather than selling

* retail investors completely burnt out of the market

* market valuations are compelling, finally: "For the first time in 50 years, the yield on US Treasuries has fallen below the dividend yield of the S&P 500." [Note also the footnote here saying that the stock market dropped another 20% from when this essay was originally written (nice honesty from the authors!); of course the market was up monstrously over the next several years].

148ff On "the other side" of the Spanish construction boom: in November 2010 the authors find opportunities appearing in Spain in the construction sector; most construction firms are down massive from the peak; "...deep pessimism about all things Spanish prevails." It turns out the firm's investment in the real estate stock Acciona underperformed meaningfully in the years that followed. [Sometimes the things all line up and yet you're still wrong.]

151ff On Ireland and the "Irish discount" after the GFC; on capital flight out of Ireland after the property-fueled Irish economic boom; review of the Anglo-Irish Bank catastrophe; Marathon participated in the Bank of Ireland's recapitalization and share issue; multiple other Irish banks were nationalized or retrenched, thus the competitive environment should be far better. Note also that Ireland did the "good bank/bad bank" method to restore the country's banking industry: they ran a state-controlled "bad bank" which took on all of the problematic loans off the other banks' balance sheets. Comments here about Bank of Ireland trading it 0.4 times book [which is a great valuation, note also after a crisis you can usually "trust" the bank's assessment of its own book value--in fact at times like these the bank may even be overly pessimistic about its book, and in the years to come it may very well revise that book value higher and higher as things don't turn out as poorly as they expect (certain bad loans turn out good, the collateral ends up being more than enough to make the lender whole, etc).]

153ff Comments here about Irish Continental Group, ICG, which runs ferries both for freight and passengers in a duopoly against the Stena Line; this industry is also in the "good" part of the capital cycle.

154ff On the European Central Bank propping up banks across the Eurozone, interfering in the capital cycle on the downturn/cleansing part of the cycle; on the French finance minister Christine Lagarde saying "Ce n'est pas possible" to the idea of SocGen bank being consolidated away; also on how the European banking sector still needs tremendous consolidation. Thus "the capital cycle is not working in the banking sector in Europe, because the creative destruction that is required is politically unacceptable."

156ff On Japan-style zombie companies all over Europe; on the fact that excess capacity built up during the credit room has yet to be purged even as late as 2012 when this note came out. Citing the European auto industry as the poster child for this problem; on French carmakers unwilling to close plants, on Volkswagen spending EUR50 billion over the next three years on capex [!]; on the European steel industry doing the same; also the European paper and aluminum industries not cutting costs and capacity in the face of Chinese capacity expansion; "From a capital cycle perspective, the above situations only become attractive when stock market valuations fall to a fraction of replacement cost and a path opens up for dealing with the excess capacity." [This is a good insight: just because something is cheap doesn't mean it will go up; you need it to be cheap plus have a set of catalysts for industry improvement too. It is not enough for it to simply be cheap!]

159 Interesting and disturbing offhand comment here about how new technologies interfere with the capital cyclea: on the idea that even though there's contraction in capacity there's an ever worse secular decline in demand. The author goes on here in a footnote to describe an absolute murderers' row of "unsuccessful investments in companies with strong incumbent positions" all of which were destroyed by digitization. The list includes the CD retailer HMV, Eastman Kodak, Blockbuster and EMI. [This is incredible, staggering that these guys invested in all these companies. How could they miss these technology cycles?] 

160ff More commentary on "living dead"-type companies here; blaming loose monetary policy, also saying that loose monetary policy doesn't actually stimulate the way people think it does, citing the European economy in 2013 remaining 2% below its level of 2007 while Japan is 1% ahead and the US 6% ahead. [I had been expecting these guys at some point to say the standard permabear line about how monetary policy is "pushing on a string"... lo and behold here it is at the bottom of page 161!]

162 Comment here on "Ricardian equivalence": the idea that government spending eventually leads to higher taxes to bail out the public sector, thus consumers lose confidence and continue to restrict their spending, even in the face of continuing fiscal deficit spending.

162 Using 1990s Japan as a paradigm here as Japan faced two lost decades and persistently low returns on equity, despite extremely low interest rate policy. Note that Japan's GDP per capita is still below 1991 and the country has huge levels of public sector debt.

162-3 Challenging the idea that low interest rates drive higher equity valuations; traditional finance theory says a lower risk-free rate implies a lower cost of capital, thus meaning a higher P/E is justified. "But it's naive to forget the reason why interest rates are so low in the first place, namely a weak economy, high leverage and the memory of a near-catastrophic financial collapse in the rearview mirror. These factors might be expected to increase investors' cost of equity assumptions warranting a lower P/E multiple." [This is sort of a strange argument: because people fear what just happened P/E's are lower?] Note also here, in a bearish 2013 note, the authors are discussing that they consider low interest rates a negative signal for equity holders, they further say that this raises the risk of another debt crisis at some future stage "this time a sovereign one." [This turned out to be exactly wrong and the better trade was to be a buyer right then.]

163ff A discussion of Thomas Piketty and his book Capital in the 21st Century; on problems with the book, the authors cite the growth paradox [see also page 48, above] where earnings per share growth for the US stock market has laged GDP growth, with the discrepancy even more pronounced abroad; the assumption in Picketty's book is that capital reproduces itself faster than GDP, which isn't borne out by reality. Next the authors move onto examples where companies in terrible financial shape are borrowing at rates much lower than they should; also that non-investment grade bonds are paying yields much lower than they should. [The reader is confused here at the jump in topics: I don't see how these things relate to their comments on Piketty. Maybe what these guys are trying to say is that capital owners who invest in below investment grade bonds are going to get separated from their money rather than compound it as Piketty thinks they might?] "Mr. Picketty can rest easy. In an age when risk free assets yield little or nothing, the determination of the wealthy to earn somewhat more will, in due course, do more to restore equality than his proposed taxes." [Yes, it turns out that is the (roundabout) argument they actually make.]

Chapter 6: China Syndrome

167ff On Marathon making very few investments in mainland China, because many firms are state-controlled, usually shareholders considered secondary to the state's policy objectives, capital isn't allocated efficiently, etc. Also an articulation of the typical macro bear case on China: that they've overinvested, that as a result of overinvestment, their productivity will be lower, and also the fact that China has to overinvest even more in order to keep their economy growing. Also on the fact that Chinese stock market is in a bubble: note that this note was written in 2016 [the Shanghai index is basically flat from then up to today, so this turned out to be a pretty predictive claim]. This chapter is a selection of essays about "some of the more curious practices of Chinese capitalism."

168ff Annualized gains from 1993 to 2003 in Chinese government-sponsored stocks [the SOEs: state-owned enterprises] was -0.6% per year and -2.9% for the full decade. A blurb here on China Telecom: right before its IPO the company raised phone call rates from Hong Kong to international destinations by 8x, which added 12.5% to the company's profits per share. "Earnings manipulation around Chinese IPOs is the norm." Also on the Sinotrans IPO which "had been created two weeks [before the deal] through a carve-out of assets, contracts, territories and employees from a much larger, state-owned entity."

171ff Further discussion of the Chinese market here and the pushback they had been getting from clients and consultants about Marathon's lack of exposure to Chinese equities during a period of good performance there; on the phrase "When the ducks quack, feed them," referring to Chinese companies created specifically for the purposes of an IPO [basically investors have to remember that the stock market literally creates "merchandise" for investors; sometimes a company is IPO'd not because it is a good move for the company per se, but rather because there's investor money out there to harvest!]; on PICC, China's leading P&C insurer and its IPO, which was carved out from a huge collection of insurance policies, some of which had gone bad and some of which hadn't, supposedly the IPO was allegedly built of the "good" policies; on the same technique to be used with major Chinese banks where their bad loans would be hived off into a state-owned asset management company and the good loans would be IPO'd. The structural problem here is that the management--the same people who made the bad loans or bad insurance underwritings in the first place--stayed the same! Other examples follow: an agricultural firm and a manufacturer of cellphone network equipment, both with significant problems. Marathon is saying that people are overpaying for "flaky businesses with no hope of sustained profitability." Note also here in a footnote Marathon admitting they were too bearish and that all these companies did very well over the ensuing several year period that followed.

174ff Comments here on government sponsored debt forgiveness in Chinese equities as an unusual brand of Chinese "capitalism": where money raised by the domestic banking system often ends up being optional to be paid back.

176ff Comments on Cinda Asset Management, which is China's leading distressed debt investor, stuffed to the gills with coal industry and real estate industry debt.

179ff On the big four Chinese Banks, discussed in a 2014 note, where they're trading around book value; the authors argue that their funding costs are artificially low and the banks are aggressively levered, and that the sector is not yet in the right part of the capital cycle.

181ff Finally comments here on the bubble-like overvaluation of the Shanghai stock market in 2015. [Again, they were right. The Shanghai Composite over the past ten years (mid-2015 to mid-2025) has a return of -5%. Over ten years!]

Chapter 7: Inside the Mind of Wall Street

[This is the weakest chapter of the book. It offers little insight; anyone who knows anything about Wall Street already knows all about the various agency problem of the investment banking industry that they satirize here; their attempts at humor using "inside baseball"-style witticisms fall flat. It's like readers will separate here into two camps: outside-the-industry readers who won't get any of the witty references, or inside-the-industry readers who do get the references, but already know all the negative proclivities of investment banking in the first place. Thus it teaches nothing.]

184ff On Marathon's suspicion and "natural wariness" of investment bankers who are in the business of supplying capital to hot areas of the stock market; this chapter contains satirical articles about a fictional investment bank called "Greedspin" and its lead banker Stanley Churn.

185ff A letter from an imaginary company called General Chocolate on their confused reaction to some of the perspectives of Marathon analysts after a meeting; they didn't like how Marathon questioned that the company should grow capacity; basically this is an attempt to show the agency problems of the investment banking industry and the companies they fund versus shareholders.

189ff Another not particularly funny piece trying to satirize the structured investment vehicles used by the investment banking industry to send debt back and forth, to and from different entities, charging fees all around.

192ff Another attempt at humor, satirizing former Treasury Secretary Hank Paulson: "Remember [former Citi CEO] Sandy Weill's rule that in our business, you just need to change the name of the product once a decade!" 

200ff Satires of an annual report, using all the proper buzzwords, like sustainability, civic engagement, etc. [This entire chapter is forgettable and should have been cut.]

Equities to consider:

Assa Abloy (Yale Locks)

Novozymes (enzymes)

Waters (chromatography)

Pall Corp (filtration)

Mettler-Toledo (measurement)

Rotork (actuators for oil and gas)***

Spirax-Sarco (steam-based engineering kits)

IMI (controls for liquids and gases)

Ahold (ADRNY: groceries, third-party food manufacturing)

Sampo (financial services, Finland)

Atlas Copco (compressors)

Sandvik (carbide tools)

Alfa Laval (fluid handling, heat exchangers)

Quiñenco (beverages, finance and shipping, Chile)

Svenska Handelsbanken (banking, Sweden)***

Reckitt Benckiser (health and nutrition products, England)

Acciona (construction, renewables, Spain)

Ferrovial (construction, Spain)

ICG (ferry service, freight, transport, Ireland) 

To Read:

Robert Axelrod: The Evolution of Cooperation 

Mark Kurlansky: Cod

John Kotter and James Heskett: Corporate Culture and Performance

Niels Kroner: A Blueprint for Better Banking

Simon Carswell: Anglo Republic: Inside the Bank that Broke Ireland

John Maynard Keynes: The Age of Uncertainty